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We are always interested in speaking to members of the media on news and events affecting the world of corporate credit risk. We look forward to hearing from you.
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Basel II Draws Attention to CDS Risk Management
Source: Securities Industry News
Date: July 26, 2004
Author: Chris Kentouris
While the Basel II Accord's efforts at improving how financial firms calculate credit and operational risk seem to have won the praises of many market players, concerns about how credit derivative contracts are tackled continue to plague the industry. And with good reason: they are among the fastest growing over-the-counter instruments.
In the minds of banking regulators who drafted the rules-that each country must now interpret-credit derivative contracts carry significant risk, which over the past few years has been distributed not only among banks but to insurance firms, reinsurers and hedge funds as well. To market players, however, credit derivatives have not only mitigated risk, but also generated multibillions in profits; indeed, because of the highly customized nature of the agreements, they are widely considered to be among the most lucrative trading instruments at a time of shrinking margins.
The volume of credit derivatives- which include credit default swaps and total return swaps-grew by 67 percent over the course of 2003 to total $3.58 trillion of notional principal amount outstanding, according to the most recent figures released by the International Swaps and Derivatives Association, the New York City-based industry trade group. A study conducted by consultancy McKinsey last year on behalf of Deutsche Bank forecast that the credit derivatives business could grow to as much as $10 trillion by 2007, with the number of actively traded credit default swaps set to double by 2007 to 600.
No one disputes that at the very least, Basel II-recently revamped for the second time -provides a more up-to-date framework than its 1998 predecessor Basel I for determining how much capital banks should have on hand to withstand credit and operational losses. Banks that use the new risk models allowed under the legislation can better align the amount of capital they're required to hold in reserve with their own economic calculations.
While the ISDA recently gave a thumbs up to the Bank of International Settlements' (BIS) overall revised framework for Basel II, it reserved a few caveats for credit derivatives. Industry participants say Basel II is too restrictive in how it allows financial institutions to measure the probability of what is known as "a double default." That is the likelihood that both the borrower of a loan and the seller of a credit default swap contract will default on their obligations.
"The answer to the question has some serious implications for how much regulatory capital a firm must set aside against credit risk. From all accounts, banks hedging credit risk by using credit default swap agreements have lower default estimates than regulators," said Emmanuele Sebton, policy director at ISDA and a former risk manager.
Jeffrey Bohn, managing director at Moody's KMV, a subsidiary of the rating agency that sells quantitative credit risk management tools and services, said that his firm's research shows that in many instances the joint default probability between a writer of credit protection and the underlying obligor on which the credit protection is written is close to zero.
"Basel II's treatment of this joint default probability is conservative as it ends up classifying all counterparties in the same fashion. It penalizes well-capitalized and better rated firms," he said.
In its basic form, a credit default swap (CDS) is essentially a contract that transfers credit risk from one party to another; the risk protection buyer pays the protection seller a premium, usually in the form of a semi-annual annuity. Banks are typically risk protection buyers of credit default swaps, which allow them to lend money to a client beyond a bank's typical risk tolerance.
Although the Federal Reserve is more limited than its European counterparts in its criteria for deciding which financial firms will fall under Basel II's requirements, the banks it has targeted are among the most active in the credit default derivatives market - large, money-center banks with about $250 billion in assets and several more with international exposures of more than $10 billion. Banks must phase in their Basel II-compliant systems over a one-year period beginning in January 2007.
All U.S. commercial banks are already required to report their credit derivative activities every quarter to the Federal Deposit Insurance Corp., but the BIS is taking the disclosure one step further. A "trading book review" committee led by the Financial Services Authority and Securities and Exchange Commission is expected to ask dealers in the credit derivatives market to supply information about their counterparties in credit default swap agreements-distinguishing among banks, insurance companies and other investors such as hedge funds. Dealers will also be asked about the maturity and geographic breakdown of their credit derivative books.
Credit derivative dealers naturally insist they have reduced risk through the use of credit derivatives, rather than increased it; Deutsche Bank, for one, has publicly disclosed that commercial banks have cut the proportion of the financial markets' credit risk they hold from between 70 percent and 75 percent to between 40 percent and 45 percent through credit derivatives.
Regulators want to know just who is absorbing the remaining risk. A move to fuller disclosure of risk transfer from banks to other financial institutions has been high on the agenda of the Committee of the Global Financial System, one of the permanent groups that meets under the auspices of the BIS. The withdrawal of some insurance companies such as Scor, the French reinsurer, from underwriting credit derivatives has assuaged some fears about a systemic collapse; but they still want to know more about how credit markets might respond to liquidity problems because two banks-J.P. Morgan Chase and Deutsche Bank-have large credit derivative books. Other major players are UBS, Commerzbank, and Credit Suisse.
"Regulators are also concerned that risk is being transferred to institutions, which are not only ill-prepared to handle it, but do not fall under the same stringent guidelines as banks," said Dean Jovic, group managing director at SunGard Trading and Risk Systems, a subsidiary of SunGard Data Systems specializing in risk management software. "Most of the world's largest commercial banks have developed sophisticated financial risk management modeling systems for credit risk, but others lag."
Insurers and reinsurers, which may be using credit derivatives as investment tools and underwriting opportunities, are exposed to a double financial hit if their credit derivative transactions turn out to be money-losing. Hedge funds, which can use credit default swaps to go short in corporate bonds, have had problems valuing the instruments as they are also underresourced in the middle and back office areas.
"Much of the risk in credit derivatives is being passed from U.S. headquartered global banks to European insurance companies, which are far less regulated than their U.S. counterparts," said Michael Haney, an analyst at Celent Communications, a New York financial technology research shop.
No one believes that compliance with the Basel II Accord-and other regulatory requirements-will cause the credit derivatives market to shrivel, but it could make the cost of trading credit derivatives higher. "Buyers of credit default swap contracts could request a bigger premium than before to take into account the fact that they cannot reduce their capital requirements by as much as anticipated," said one New York-based credit derivatives trader, who requested anonymity.
Indeed, others warn that regulators should be careful not to discourage the transference of risk in the credit derivatives market in a way that does more harm than good. "Banks will still want to enter into credit default swap agreements to diversify their portfolios, but in hampering sellers of the credit default swaps they will be concentrating the risk in fewer hands," said Andrew Wilson, a partner in the financial services practice of consultancy Accenture.
On a positive note, the Basel II Accord could bring about some badly needed operational changes. It will likely compel financial firms to automate how they handle some of the middle-office processing related to credit derivatives, which today is typically done manually and is error-prone.
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